AN ASSIGNMEMT

ON

ASSETS – LIABILITIES MANAGEMENT

PROPRIETORY IN BANKS

SUBMITTED BY
SHAH PRIYANK (47)

SUBMITTED TO
PROF. KAUMADI UPADHYAY

ACADEMIC YEAR
2007-09

SUBMITTED TO
S.V. INSTITUTE OF MANAGEMENT, KADI

AFFILIATED TO
HEMCHANDRACHARYA NORTH GUJARAT UNIVERSITY
PATAN
 INTRODUCTION

“If there is any area of banking that has undergone drastic change, it is the whole
subject of assets/liabilities management.”
- Paul S. Nadler

“Strong capital will not guarantee liquidity in all circumstances. There can be
panics and sudden increase in the demand for liquidity. It is the job of the central
banks to help in those circumstances. But a strong capital base in the system
and in all its components is likely to limit future liquidity shocks.
- Jean Pierre Landau,
Deputy Governor, Bank of France

Liquidity management is a provoking idea for the management of the financial

institutions to ponder about and act. But how to act and when to act are the
questions which lead to Assets and Liability Management (ALM), a management
tool to monitor and manage various aspects of risks associated with the balance
sheet management , including the management and balance sheet exposure of
the institutions. In other words, “ALM is an ongoing process of formulating,
monitoring, revising and framing strategies related to assets and liabilities in an
attempt to achieve the financial objective of maximizing interest spread or
margins for a given set of risk level.” It is not only a liquidity management tool,
but also a portfolio management tool to alter the composition of assets and
liability portfolio to manage the risk by using various risk mitigating measures.

Assets/liability management is an integral part of the planning process of

commercial banks. In fact, asset/liability management may be considered as one
of the three principal components of a planning system. The three components
are:

• Asset/liability management which focuses primarily on the day-to-day or

week-to-week balance sheet management necessary to achieve short term
financial goals.
• Annual profit planning and controls which focus on slightly longer term goals
and look at a detailed financial plan over the course of a fiscal or calendar
year.
• Strategic planning which focuses on the long run financial and non financial
aspects of a bank’s performance.
 CONCEPT OF ALM

ALM is a system of matching cash inflows and outflows in the system, and is thus
a management tool of liquidity management. Hence, if a bank meets its Cash
Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) stipulation regularly
without undue and frequent resort to purchased / borrowed funds and without
defaults, it can be said to have a satisfactory system of managing liquidity risks
and so, of ALM. The spread between the deposit and lending rates were wide
and also were more or less uniform and changed only at the instance of the RBI.
Clearly, the institutions, themselves were not managing the balance sheet; it was
being ‘managed’ and controlled through prescriptions of the regulatory authority
and the government. Ever since the initiation of the process of deregulation and
liberation of interest rates and consequent injection of a dose of competition, the
need for ALM was felt. With deregulation of interest rates and greater freedom
being given to the organizations to decide and mange the cost of lending and
borrowing and ultimately management of the balance sheet. Hence, the need for
a system such as ALM, which could provide the necessary framework to define,
measure, monitor, modify and manage the interest risk.

Asset/liability management focuses on the net interest income if the institutions.

Net interest income is the difference between the amount of interest received
from loans and investments and the amount of interest paid for deposits and
other liabilities.

Net interest income = interest revenue – interest expense

Expressing the net interest income as a percentage of earning allows us to

express the interest income as a margin. The total net interest income may not
be meaningfully compared between banks of different size but the margin may
be meaningfully compared.

Net interest margin = Net interest income / earning assets

 HISTORICAL PERSPECTIVE

The ALM, historically, has evolved from the early practice of managing liquidity
on the bank’s asset side, to a later shift to the liability side and termed liability
management, to a still later realization of using both the assets as well as the
liabilities side of the balance sheet to achieve optimum resources management,
i.e., an integrated approach. Prior to deregulation, bank funds were obtained
from relatively stable demand deposits and from small time deposits. Interest rate
ceiling limited the extent to which banks could compete for funds. Opening more
branches in order to attract fresh deposits. As a result, most sources of funds
were core deposits which were quite impervious to interest rate movements in
this environment bank fund management concentrate on the control of assets.
The bank’s ability to grow will be hampered if they do not have access to the
funds required to create assets. They have freedom to obtain funds by borrowing
from both the domestic and international markets. As they tap different source of
funds, there is an increased need for liability management and it becomes an
important part of their financial management.

With liability management, banks now have two sources of funds – core deposits
and purchased funds – with quite different characteristics. For core deposits, the
volume of funds is relatively insensitive to changes in interest rate levels. From
the perspective of the management, the core deposits offer the advantage of
stability. However core deposits have the disadvantage of not being overly
responsive to management needs for expansion. If a bank experiences a
sizeable increase in loan demand, it can not expect the core deposits to increase
proportionately. For purchased funds, however, the bank can obtain all the funds
that it wants if it is willing to pay the market determined price. Unlike core
deposits where the bank determines the price, the interest rates on purchased
funds are set in the national money market. The bank can be thought of as a
price taker in the purchased funds market whereas in the core deposit market it
can be viewed as a price setter. The purchased funds give complete flexibility in
terms of the volumes and timing of the availability of funds.
 MODERN PERSPECTIVE

The recent volatility of interest rates broadened to include the issue of credit risk
and market risk and to ensure that their risk management capabilities are
commensurate with the risk of their business. The induction of credit risk into the
issue of determining adequacy of bank capital further enlarged the scope of ALM.
According to policy approach of Basel II in India, to conform to best international
standards and in the process emphasis is on harmonization with the international
best practices. If this were so, the scope and the role of ALM becomes all the
more enlarged. Incidentally, commercial banks in India will start implementing
Basel II with effect from March 31, 2008 though, as indicated by the governor of
the RBI, a marginal stretching beyond this date can not be ruled out in view of
latest indications of the state of preparedness.

In current spell, earning a proper return for the promoter of equity and
maximization of its market value means management of the balance sheet of the
institution. In other words, this also implies that managements are now expected
to target required profit levels and ensure minimization of risks to acceptable
levels, to retain the interest of the investing community. In today’s competitive
environment, if the organization has to remain in the business, costing and
product pricing policies have to be suitably structured. Thus, with the changing
requirement, there is a need for not only managing the net interest margin of the
organization but at the same time ensuring that liquidity is managed, how much
liquid the organization has to be definitely, worked out on the basis of scenario
analysis, but the knowledge to management, adopt the new system and
organizational changes that are called for it to manage, have to be defined. Thus,
the concept of ALM is much wider and is of greater significance.

The ALM process rests on three pillars:

• · ALM information systems

=> Management Information System
=> Information availability, accuracy, adequacy and expediency
·
• ALM organisation
=> Structure and responsibilities
=> Level of top management involvement
·

• ALM process
=> Risk parameters
=> Risk identification
=> Risk measurement
=> Risk management
=> Risk policies and tolerance level
ALM information systems

Information is the key to the ALM process. Considering the large network of
branches and the lack of an adequate system to collect information required for
ALM which analyses information on the basis of residual maturity and
behavioural pattern it will take time for banks in the present state to get the
requisite information. The problem of ALM needs to be addressed by following an
ABC approach i.e. analysing the behaviour of asset and liability products in the
top branches accounting for significant business and then making rational
assumptions about the way in which assets and liabilities would behave in other
branches. In respect of foreign exchange, investment portfolio and money market
operations, in view of the centralised nature of the functions, it would be much
easier to collect reliable information. The data and assumptions can then be
refined over time as the bank management gain experience of conducting
business within an ALM framework. The spread of computerisation will also help
banks in accessing data.

ALM organization

a) The Board should have overall responsibility for management of risks and
should decide the risk management policy of the bank and set limits for
liquidity, interest rate, foreign exchange and equity price risks.

b) The Asset - Liability Committee (ALCO) consisting of the bank's senior

management including CEO should be responsible for ensuring adherence to the
limits set by the Board as well as for deciding the business strategy of the bank
(on the assets and liabilities sides) in line with the bank's budget and decided risk
management objectives.

b) The ALM desk consisting of operating staff should be responsible for

analysing, monitoring and reporting the risk profiles to the ALCO. The staff
should also prepare forecasts (simulations) showing the effects of various
possible changes in market conditions related to the balance sheet and
recommend the action needed to adhere to bank's internal limits.

The ALCO is a decision making unit responsible for balance sheet planning from
risk - return perspective including the strategic management of interest rate and
liquidity risks. Each bank will have to decide on the role of its ALCO, its
responsibility as also the decisions to be taken by it. The business and risk
management strategy of the bank should ensure that the bank operates within
the limits / parameters set by the Board. The business issues that an ALCO
would consider, inter alia, will include product pricing for both deposits and
advances, desired maturity profile of the incremental assets and liabilities, etc. In
addition to monitoring the risk levels of the bank, the ALCO should review the
results of and progress in implementation of the decisions made in the previous
meetings. The ALCO would also articulate the current interest rate view of the
bank and base its decisions for future business strategy on this view. In respect
of the funding policy, for instance, its responsibility would be to decide on source
and mix of liabilities or sale of assets. Towards this end, it will have to develop a
view on future direction of interest rate movements and decide on a funding mix
between fixed vs floating rate funds, wholesale vs retail deposits, money market
vs capital market funding, domestic vs foreign currency funding, etc. Individual
banks will have to decide the frequency for holding their ALCO meetings.

Composition of ALCO
The size (number of members) of ALCO would depend on the size of each
institution, business mix and organisational complexity. To ensure commitment of
the Top Management, the CEO/CMD or ED should head the Committee. The
Chiefs of Investment, Credit, Funds Management / Treasury (forex and
domestic), International Banking and Economic Research can be members of the
Committee. In addition the Head of the Information Technology Division should
also be an invitee for building up of MIS and related computerisation. Some
banks may even have sub-committees.

Committee of Directors
Banks should also constitute a professional Managerial and Supervisory
Committee consisting of three to four directors which will oversee the
implementation of the system and review its functioning periodically.

ALM process:
The scope of ALM function can be described as follows:
 Liquidity risk management
 Management of market risks
(including Interest Rate Risk)
 Funding and capital planning
 Profit planning and growth projection
 Trading risk management
The guidelines given in this note mainly address Liquidity and Interest Rate risks.
Credit risk management

Credit risk management plays a vital role in the way banks perform. It reflects

- The profitability
- Liquidity
- Reduced NPAs.

Credit risk management is a process that puts in place systems and procedures
enabling a bank to-
- Identify & measure the risk involved in a credit proposition, both at
the individual transaction and portfolio level.
- Evaluate the impact of exposure on bank’s financial statements.
- Assess the capability of risk mitigates to hedge/ insure risks.
- Design an appropriate risk management strategy to arrest “risk-
migration”.

Way for Credit Risk Management:-

Credit risk management is done at two levels-Micro level & Macro level.As
the credit risk management at micro-level is focused on clients, the efficiency
level of the operating staff in credit evaluation and monitoring needs to be honed
up.

In macro level approach to credit risk management, the Capital Adequacy

Ratio (CAR) plays a crucial role. The bank management stipulates the industry
exposures keeping the overall position of its credit deployment.

Risk transfer is a popular risk management technique being used today.

The development of credit derivatives is a logical extension of two of the most
significant developments such as securitization and derivatives. A credit asset is
a bundle of risks and returns. And every asset is acquired to make certain
returns. However, the probability of not making the expected return is the default
risk associated with every credit asset. One of the alternatives available to a
bank in managing credit risk is the use of credit derivatives. Credit derivatives
facilitate risk transfer. This concept has picked up momentum in the US and
European markets and is yet to pick up in India. Considering the pathetic
scenario of loan portfolio in Indian banks, our regulators can explore the
possibilities of developing instruments facilitating credit risk transfer.
 MEASURING INTEREST RATE SENSITIVITY

The most commonly used measure of the interest rate position of a bank is Gap
analysis. The Gap is the difference between the amount of the rate sensitive
assets and rate sensitive liabilities. The Gap may be expressed in a variety of
ways. The simplest is the rupee Gap – the difference between the amounts of
RSA and RSL expressed in rupees. Some other measures of Gap are the relative
Gap ratio, which is the ratio of the rupee Gap and the Total assets. Another
measure is the interest rate sensitivity ratio, which is the ratio of the RSA to RSL.

Relative Gap ratio = Rupee Gap / Total assets

Interest rate sensitivity ratio = RSA / RSL

A bank at a given time may be asset or liability sensitive. If the bank were asset
sensitive, it would have a positive Gap, appositive relative Gap ratio and an
interest sensitivity ratio greater than one. Conversely, a bank that is liability
sensitive would have a negative Gap, a negative relative Gap ratio and interest
sensitivity ratio less than one. Banks that are asset sensitive experience an
increase in their net interest income when interest rate increase and vice – versa.
Conversely, banks that are liability sensitive see their net interest income
decrease when interest rate and vice – versa. The below table summarises the
effects interest rate changes on net interest income for different Gap positions.

Effects of Changes in Interest Rates

Gap Changes in Interest Changes in Net Interest Rate

Rate
Positive Increase Increase
Positive Decrease Decrease
Negative Increase Decrease
Negative Decrease Increase
Zero Increase Zero
Zero Decrease Zero

The focus of asset/liability management is on interest rate risk. However, a

management is concerned with managing the entire risk profile of the institutions,
including interest risk, credit risk, liquidity risk and other dimensions of risk. If
those risk were unrelated, then managers could concentrate on one type of risk,
making appropriate decisions and ignoring the effect of the decisions on the
other types of risks. However, the different types of risks have a high degree of
correlation, especially the interest rate risk and the credit risk.

CLASSIFICATION OF ASSETS AND LIABILITIES

 ASSETS CLASSIFICATION LIABILITIES CLASSFICATION
AND CAPITAL
Vault cash NRSA Demand NRSL
deposits
Short term securities RSA Current accounts NRSL
Long term securities NRSA Money market RSL
deposits
Variable rate loans Short term RSL
RSA deposits
Short term loans RSA Long term saving NRSL
Long term loans NRSA Repo transaction RSL
Other assets NRSA Equity NRS

The above table shows the classification of the assets and liabilities of a bank
according to their interest rate sensitivity. Those assets and liabilities whose
interest return or costs vary with interest rate changes over some time horizon
are referred to as Rate Sensitive Assets(RSA) or Rate Sensitive Liabilities(RSL).
Those assets or liabilities whose interest return or costs do not vary with interest
rate movements over the same time horizon are referred to as Non – rate
Sensitive Assets (NRSA) or Non – rate Sensitive Liabilities (NRSL). It is very
important to note that the critical factor in the classification is the time horizon
chosen. An asset or liability that is time sensitive in a certain time horizon may
not be sensitive in a shorter time horizon and vice – versa. However, over a
sufficiently long time horizon, virtually all assets and liabilities are interest rate
sensitive. As the time horizon is shortened, the ratio of rate sensitive to non rate
sensitive assets and liabilities falls. At some sufficiently short horizon, say one
day, virtually all assets and liabilities are non interest rate sensitive.

Liquidity Risk Management

 Measuring and managing liquidity needs are vital activities of commercial banks.
By assuring a bank's ability to meet its liabilities as they become due, liquidity
management can reduce the probability of an adverse situation developing. The
importance of liquidity transcends individual institutions, as liquidity shortfall in
one institution can have repercussions (indirect effect) on the entire system.
Bank management should measure not only the liquidity positions of banks on an
ongoing basis but also examine how liquidity requirements are likely to evolve
under crisis scenarios. Experience shows that assets Commonly considered as
liquid like Government securities and other money market instruments could also
become illiquid when the market and players are unidirectional. Therefore
liquidity has to be tracked through maturity or cash flow mismatches. For
measuring and managing net funding requirements, the use of a maturity ladder
and calculation of cumulative surplus or deficit of funds at selected maturity dates
is adopted as a standard tool.

The Maturity Profile could be used for measuring the future cash flows of banks
in different time buckets. The time buckets given the Statutory Reserve cycle of
14 days may be distributed as under:

i) 1 to 14 days
ii) 15 to 28 days
iii) 29 days and upto 3 months
iv) Over 3 months and upto 6 months
v) Over 6 months and upto 12 months
vi) Over 1 year and upto 2 years
vii) Over 2 years and upto 5 years
viii) Over 5 years

LIQUIDITY MANAGEMENT IN FINANCIAL INSTITUTIONS

As mentioned earlier, “Strong capital will not guarantee liquidity in all
circumstances. There can be panics and sudden increases in the demand for
liquidity.” How regulatory authorities view liquidity concerns and how they meet
the requirement of the institutions can be better understood from the statement
by Reserve Bank of India Governor, which states, “liquidity management is
carried out through Open Market Operation (OMO) in the form of out right
purchase / sales of government securities and reverse repo / repo operations,
supplemented by the newly introduced Market Stabilization Schemes(MSS). The
Liquidity Adjustment Facility (LAF), introduced in June 2000, enables the RBI to
modulate short term liquidity, of a temporary nature, under varied financial market
conditions in order to ensure stable conditions in the overnight (call) money
market.” In addition to above requirement met by the regulatory authorities i.e.,
the RBI, financial institutions manage their liquidity concern in many ways by
employing various available tools such as:
Liquid Assets
Different regulatory authorities in different parts of the world have prescribed
financial institutions to maintain certain percentage of liquid assets to their
liabilities. For instance, the central bank of Solomn Islands requires financial
institutions to maintain a minimum liquid assets of 7% of liabilities. Similarly, the
RBI has prescribed CRR and SLR . Composition of the same could vary with the
requirements.

By Setting a Limit on Maturity Mismatches

Financial institutions could also monitor and control the gaps between maturing
assets and liabilities in various time buckets. The maturity profile should take into
account the off – balance sheet exposure and its cash flows. The construction of
such maturity profile relies heavily on assumptions that certain proportion of
maturing liabilities will be able to rollover, by the financial institutions. Short term
maturity gaps in the shorter time periods, say 1 to 7 days bucket. Various
regulatory agencies have prescribed limits and control measures to monitor this
aspect.

A Diversified Source for Liability Raising

As part of overall liquidity management, institution should seek to maintain a well
diversified funding base and at the same time understand that frequently
approaching markets on such borrowed funds could be costly affair. The market
also responds very adversely so such frequent approaches and regulatory
agencies have been cautioning against this practice of dependence on such
short term sources.

By Availing Funds from the Wholesale Markets

The ability to raise funds in the inter- bank market or other wholesale markets
can be an important source of liquidity but this may be substantially reduced or
delayed in a crisis conditions. Financial institutions could estimate their
requirement liquidity and lay down board approved policies in this regard.

To Have Boards – approved Contingency Plan

A well though out plan approved by the board could include procedure for dealing
with major liquidity problems, suggestions for corrective course of action and
details for dealing with public and media personnel, etc.

Currency Risk Management

Floating exchange rate arrangement has brought in its wake pronounced
volatility adding a new dimension to the risk profile of banks' balance sheets. The
increased capital flows across free economies following deregulation have
contributed to increase in the volume of transactions. Large cross border flows
together with the volatility has rendered the banks' balance sheets vulnerable to
exchange rate movements.

Dealing in different currencies brings opportunities as also risks. If the liabilities

in one currency exceed the level of assets in the same currency, then the
currency mismatch can add value or erode value depending upon the currency
movements. The simplest way to avoid currency risk is to ensure that
mismatches, if any, are reduced to zero or near zero. Banks undertake
operations in foreign exchange like accepting deposits, making loans and
advances and quoting prices for foreign exchange transactions. Irrespective of
the strategies adopted, it may not be possible to eliminate currency mismatches
altogether. Besides, some of the institutions may take proprietary trading
positions as a conscious business strategy.

Managing Currency Risk is one more dimension of Asset- Liability Management.

Presently, the banks are also free to set gap limits with RBI's approval but are
required to adopt Value at Risk (VaR) approach to measure the risk associated
with forward exposures. Thus the open position limits together with the gap limits
form the risk management approach to forex operations.
HYPOTHETICAL EXAMPLE OF MISMATCH BETWEEN ASSETS
AND LIABILITIES

Consider a bank that borrows USD 100MM at 3.00% for a year and lends the
same money at 3.20% to a highly-rated borrower for 5 years. For simplicity,
assume interest rates are annually compounded and all interest accumulates to
the maturity of the respective obligations. The net transaction appears profitable
—the bank is earning a 20 basis point spread—but it entails considerable risk. At
the end of a year, the bank will have to find new financing for the loan, which will
have 4 more years before it matures. If interest rates have risen, the bank
may have to pay a higher rate of interest on the new financing than the fixed 3.20
it is earning on its loan.

Suppose, at the end of a year, an applicable 4-year interest rate is 6.00%. The
bank is in serious trouble. It is going to be earning 3.20% on its loan and paying
6.00% on its financing. Accrual accounting does not recognize the problem. The
book value of the loan (the bank's asset) is:

100MM(1.032) = 103.2MM

The book value of the financing (the bank's liability) is:

100MM(1.030) = 103.0MM

Based upon accrual accounting, the bank earned USD 200,000 in the first year.

Market value accounting recognizes the bank's predicament. The respective

market values of the bank's asset and liability are:

100MM (1.032)5/(1.060)4=92.72MM

100MM(1.030) = 103.0MM

From a market-value accounting standpoint, the bank has lost USD 10.28MM.

So which result offers a better portrayal of the bank' situation, the accrual
accounting profit or the market-value accounting loss? The bank is in trouble,
and the market-value loss reflects this. Ultimately, accrual accounting will
recognize a similar loss. The bank will have to secure financing for the loan at the
new higher rate, so it will accrue the as-yet unrecognized loss over the 4
remaining years of the position.

(Source: RiskGlossary.com)
The problem in this example was caused by a mismatch between assets and
liabilities. Prior to the 1970's, such mismatches tended not to be a significant
problem. Interest rates in developed countries experienced only modest
fluctuations, so losses due to asset-liability mismatches were small or trivial.
Many firms intentionally mismatched their balance sheets. Because yield curves
were generally upward sloping, banks could earn a spread by borrowing short
and lending long.

Things started to change in the 1970s, which ushered in a period of volatile

interest rates that continued into the early 1980s. US regulation Q, which had
capped the interest rates that banks could pay depositors, was abandoned to
stem a migration overseas of the market for USD deposits. Managers of many
firms, who were accustomed to thinking in terms of accrual accounting, were
slow to recognize the emerging risk. Some firms suffered staggering losses.
Because the firms used accrual accounting, the result was not so much
bankruptcies as crippled balance sheets. Firms gradually accrued the losses
over the subsequent 5 or 10 years.
 STRATEGIES FOR ASSET / LIQUIDITY MANAGEMENT

The principal purpose of asset / liability management has been to control the size
of the net interest income. The control may be defensive or aggressive. The goal
of defensive asset/liability management is to insulate the net interest income from
changes in interest rates. In contrast, aggressive asset/liability management
focuses on increasing the net interest income by altering the portfolio of the
institution.

Both defensive and aggressive asset / liability management relate to the

management of the interest rate sensitivity position of the asset and liability
portfolio of the bank, and the success or failure of the strategies depend upon the
effects of interest rates. For the success of the aggressive asset / liability
management, it is necessary to forecast future interest rate changes. On the
other hand, defensive strategy does not require the forecast of future interest rate
changes. The attempt is to isolate the bank from either an increase or decrease
in the rates.

USING FUTURES, OPTIONS AND SWAPS

Some relatively new techniques that can be used by banks to mange their asset /
liability portfolio include future, option and swaps. Although these instruments
have come into vogue in the last two decades in the US and Europe, they have
experienced a tremendous growth and are becoming very significant in asset /
liability management. Although these techniques are used primarily in defensive
asset / liability management, they can also be used in aggressive management.

The adjustments to the bank’s portfolio involve changing the current cash or spot
market positions in the portfolio of assets and liabilities. Equivalent adjustment in
the bank’s interest sensitive positions can be achieved through transactions in
the future markets. A future contract is a standardized agreement to buy or sell a
specified quantity of a financial instrument on a specified future date at a set
price. These future transactions in effect create synthetic positions with interest
sensitivity positions different from those currently held in the portfolio.

One of the other major techniques used to manage interest rate risk is the
interest rate swap. In an interest rate swap, two firms that want to change their
interest rate exposure in different directions get together (usually through an
intermediary) and exchange(swap) their obligation to pay interest. Only the
interest is swapped and not the principal. Compared to futures, swaps have both
advantages and disadvantages. First swaps may be customized to meet the
needs of the banks. Secondly, swaps can be arranged for longer terms (say 3 to
10 years) whereas futures contracts are usually of shorter duration (usually under
6 months). Swaps also have disadvantage compared to future contract. As
swaps are customized contracts, it involves time (and expense) in getting the
right swap transactions. Second due to the customization, it is difficult to correctly
evaluate a swap and close out a contract, compared to futures. Equally
significantly, the bank that enters into a swap agreement faces the risk of
counterparty default.

AGGRESSIVE GAP MANAGEMENT

Management may choose to focus on the Gap in controlling the interest rate risk
of its portfolio. This strategy seeks to profit from the anticipated interest rate
movements. With an aggressive interest rate risk management programme, the
first step is to make a prediction of future interest rates. Second, adjustments are
made to the interest sensitivity of the assets and liabilities in order to take
advantage of the projected changes in rates. The prediction of rising interest
rates generally results in shifting to a positive gap, whereas the prediction of
falling interest rates generally results in shifting the portfolio to a negative Gap
position.

DEFENSIVE GAP MANAGEMENT

In a defensive Gap management strategy, the aim is to reduce the volatility of the
net interest income. Unlike the aggressive strategy, there is no attempt to profit
from the anticipated change in rates. The defensive strategy attempts to keep the
volume of rate sensitive assets in balance with that of rate sensitive liabilities
over a given period. If successful, an increase in the interest rates will produce
equal increases in interest revenue and interest expense, with the result that net
interest income and net interest margin will not change.

It is important to note that a defensive strategy is not necessarily a passive

strategy. Continuous adjustments to the assets and liability portfolio are
necessary to maintain zero Gap. For example, suppose a variable rate loan was
paid off. If the Gap were zero prior to the pay-off, it would be negative afterwards
and adjustments will have to be made. In order to restore the zero Gap, the
manager would have to add short term securities.

PROBLEMS IN GAP MANAGEMENT

Although widely used in practice, Gap, management (whether aggressive or

defensive) has a number of drawbacks. The first complication is the selection of
the time horizon. As discussed earlier, the separation of assets and liabilities into
rate sensitive and non – rate sensitive requires the establishment of a time
horizon. Although necessary, the selection of the time horizon causes problems
because it ignores the time at which the interest rate sensitive assets are
repriced, implicitly assuming that all rate sensitive assets and liabilities are
repriced on the same day. As examples of the problem caused by such an
assumption, consider a bank which has zero Gap. Further assume that the
maturity of the rate sensitive assets is one day, that of the rate sensitive liabilities
30days and the time horizon selected is 30days.given these assumptions,
interest rate changes clearly would affect the net interest income of the bank
even though it had zero Gap. One common solution to this problem is to divide
assets and liabilities into separate categories referred to as maturity buckets and
mange each maturity bucket separately. With the buckets, Gap management
becomes management of the different buckets. The Gap for each maturity bucket
is referred to as an incremental Gap. The incremental Gap of all the buckets is
added to get the total Gap.

The second problem with Gap management is the implicit assumption that the
correlation coefficient between the movement in general market interest rate and
the interest revenue and costs to the bank are constant. In other words, if interest
rat rise or fall by one percent, the revenues and interest costs to the bank will
also rise or fall by one percent. One method of dealing with the problem
imperfect correlation is the use of standardized Gap. This measure of Gap adjust
for the different interest rate volatilities of various assets and liabilities. It uses the
historical relationship between market rates and rates for a bank’s asset and
liability items in order to alter the maturity and therefore the sensitivity of the
portfolio items.

A problem related to aggressive Gap management is the need to make interest

rate forecasts. With a lot of assumptions, rate forecast are made and based on
these a number of decision are made. A final problem with the Gap management
is its narrow focus on net interest income as opposed to shareholder wealth. An
asset/liability manager may adjust portfolio so that the net interest income will
rise with changes in interest income but the value of shareholder wealth may
decrease. Aggressive asset/liability management based on interest rate
predictions may increase the risk of loss. If successful, aggressive Gap
management may increase net income but add to the volatility of that income.

DURATION GAP MANAGEMENT

The deficiencies of traditional Gap management, especially the focus on

accounting income rather than on the market value of the equity, have
encouraged a search for alternative approaches to asset/liability management
one such approach is Duration Gap management. Duration analysis focuses
directly on the market value of the equity of the bank, where market value
represents the present value of the current and expected future income. With this
analysis, durations of the assets and liabilities of the bank are computed in order
to estimate the effects of changing interest rates on the market value of the
assets and liabilities. Once the duration are computed, the effects of changing in
interest rates can be measured simply by taking the sum of the changes in the
market value of the assets and liabilities.
As in the case of traditional Gap management, there are two strategies that can
be adopted with Duration Gap management – aggressive and defensive. The
aim in the aggressive duration gap management is to maximize the market value
of the equity. A defensive duration gap management would aim to isolate the
market value of the equity from changes in the interest rates. The below table
summarises the effects of interest rate changes on different types of Duration
Gap.

Duration Net Interest Income Change in Market Value

Gap of Equity
Positive Increase Decrease
Positive Decrease Increase
Negative Increase Increase
Negative Decrease Decrease
Zero Increase Zero
Zero Decrease Decrease

PROBLEMS IN DURATION GAP MANAGEMENT

Compared to the traditional Gap management, Duration Gap management

provides additional insights which are useful to the asset/liability manager.
However, it also suffers from several drawbacks. The primary drawback of
Duration Gap management is that this technique is only effective if interest rates
across different maturities move up or down by the same amount, i.e., a parallel
shift in the yield curve. Unfortunately this assumption is not valid, as short term
interest rates tend to move up faster than long term rates. Also in the case of
falling rates, the short term rates fall much faster than the long term rates. An
additional problem arises if the asset and liability durations are significantly
different. In that case, comparing durations is not enough and additional
measures such as convexity are required. The final problem is usually referred to
as the duration drift. This is the problem where some items in the portfolio have a
faster rate of decrease in the duration compared to others. In that case, zero
duration portfolios may suddenly become positive or negative duration gap
portfolios. This problem can be mathematically understood if we look at duration
as the first derivative and that changes in the first derivative depend on the price
yield curve of the instrument.
 ROLE OF RESERVE BANK OF INDIA

The RBI, through its credit policy announcements, various directives and
guidelines on ALM, has spelt out the need for having a comprehensive risk
management policy. The RBI, in its monetary and credit policy and subsequent
guidelines issued in February 1999, recommended that an adequate system of
ALM be put in place. Further, it even suggested that financial institutions should
introduce ALM, which would primarily focus on liquidity management and interest
rate risk management. Having, thus, laid these requirements to implement ALM,
in the stated order:

(A) Developing a better understanding of ALM concepts

(B) Introducing an ALM information system
(C) Setting up ALM decision – making process (ALM committee / ALCO), it is
for the institutions to act and implement the same.

ROLE OF FINANCIAL INSTITUTIONS

The concept of ALM and setting up the decision making process i.e., ALM
committee have fairly established in the system. Binder and Lindquist, who
conducted a study for Bank Administration Institute, highlighted the importance of
asset liability. They reported that there was a strong agreement among the banks
that ALM committee “is the single most important management group and
function in the bank.” However, the introduction of ALM information system and
implementing the process has been a tough task for the institutions. It has, at the
same time, thrown up new challenges for the institutions. Challenges in the
interest rate movements, their volatility and resistance to adopt a new procedural
requirement, etc.
EXAMPLE:
United Western Bank to merge with IDBI
PROBLEMS
There were several problems that led to the fall of UWBL that once had reached
the 'A' class bank category. Irregular transactions with some of its major
shareholders, conflicts between its major shareholders regarding the ownership
of the bank, poor governance and inefficient management of capital were the
main reasons for its collapse.

FINANCIALS OF UWB

UWB reported a net loss of Rs 104 crore on total income of 547 crore for the
financial year 2005-06. For the quarter ended 30 June 2006, the bank posted a
loss of Rs 6.1 crore on total income of around Rs 155 crore. Equity capital and
reserves were close to Rs 114 crore but capital adequacy was just 0.67 per cent
as of the end of June 2006, as against the RBI norm of 9 per cent.

Non-performing or bad assets in the books of UWB are estimated at around Rs

200 crore as of end June 2006. Most bankers expect UWB's bad assets to
increase considerably, once a proper evaluation is made.

It is very clear that bad loans have wiped out the entire net worth of the UWB.
The bank was planning a rights issue to shore up its capital base and had last
month filed a draft offer letter with SEBI.

IDBI announced that the financial performance of UWBL would be merged with
the financial performance of IDBI in the third quarter of the financial year 2006-07

EXAMPLE :

One example is the US mutual life insurance company the Equitable. During the
early 1980s, the USD yield curve was inverted, with short-term interest rates
spiking into the high teens. The Equitable sold a number of long-term guaranteed
interest contracts (GICs) guaranteeing rates of around 16% for periods up to 10
years. During this period, GICs were routinely for principal of USD 100MM or
more. Equitable invested the assets short-term to earn the high interest rates
guaranteed on the contracts. Short-term interest rates soon came down. When
the Equitable had to reinvest, it couldn't get nearly the interest rates it was paying
on the GICs. The firm was crippled. Eventually, it had to demutualize and was
acquired by the Axa Group.
Increasingly, managers of financial firms focused on asset-liability risk. The
problem was not that the value of assets might fall or that the value of liabilities
might rise. It was that capital might be depleted by narrowing of the difference
between assets and liabilities—that the values of assets and liabilities might fail
to move in tandem. Asset-liability risk is a leveraged form of risk. The capital of
most financial institutions is small relative to the firm's assets or liabilities, so
small percentage changes in assets or liabilities can translate into large
percentage changes in capital.

Exhibit 1 illustrates the evolution over time of a hypothetical company's assets

and liabilities. Over the period shown, the assets and liabilities change only
slightly, but those slight changes dramatically reduce the company's capital
(which, for the purpose of this example, is defined as the difference between
assets and liabilities). In Exhibit 1, the capital falls by over 50%, a development
that would threaten almost any institution.

Example: Asset-Liability Risk

Exhibit 1

Asset-liability risk is leveraged by the fact that the values of assets and liabilities
each tend to be greater than the value of capital. In this example, modest
fluctuations in values of assets and liabilities result in a 50% reduction in capital

(Source: RiskGlossary.com)

Techniques for assessing asset-liability risk came to include gap analysis and
duration analysis. These facilitated techniques of gap management and duration
matching of assets and liabilities. Both approaches worked well if assets and
liabilities comprised fixed cash flows. Options, such as those embedded in
mortgages or callable debt, posed problems that gap analysis could not address.
Duration analysis could address these in theory, but implementing sufficiently
sophisticated duration measures was problematic. Accordingly, banks and
insurance companies also performed scenario analysis.

Techniques for assessing asset-liability risk came to include gap analysis and
duration analysis. These facilitated techniques of gap management and duration
matching of assets and liabilities. Both approaches worked well if assets and
liabilities comprised fixed cash flows. Options, such as those embedded in
mortgages or callable debt, posed problems that gap analysis could not address.
Duration analysis could address these in theory, but implementing sufficiently
sophisticated duration measures was problematic. Accordingly, banks and
insurance companies also performed scenario analysis.
 CONCLUSION

One of the key conclusions from this analysis is that banks should take some
amount of risk in their asset/liability management, but they should never wager
their future on interest rate predictions. The financial institutions have recognized
the importance of ALM, its utility in addressing the liquidity concerns and in
managing the risk that the institutions are exposed to. The need of the hour is
prudent and diligent management of these risks. How to manage them is the
challenge and if it is successfully managed, the rewards could be stunning. The
Deputy Governor of the RBI says, “Going forward, there will be a continuous
need to adopt the strategy of liquidity management. the key questions we
continue to face are what should be the instruments and modes of management
of liquidity in the interest of growth and financial stability.
 BIBLIOGRAPHY

BOOKS :

 Managing Indian Banks, The Challenges Ahead, 2nd Edition, Sage

publication, Author – Vasant C. Joshi & Vinay V. Joshi, chapter 11,
Asset/liability management Pg No. 226 to 238

MAGAZINES:

 E. N. Murthy, “Managing assets and liabilities”, ICFAI journal Professional

Banker(March 2008) Pg No. 11 to 13